1. Field of the Invention
The present invention relates to the field of financial instruments and, in particular, to a security futures contract with a selectable expiration date and the trading, clearing, and settlement of the same.
2. Description of the Related Prior Art
Generally speaking, a futures contract is an agreement to buy or sell a financial instrument, such as a commodity or equity share, at a price fixed on the contract date at some point in the future. Consistent with this general definition, a “security futures” contract is an agreement between two parties to purchase or sell, at a future date, a specified quantity of shares of a single equity security, exchange traded fund, or a narrow-based securities index at a certain price. A buyer's or seller's position in a security futures contract can be eliminated by executing an offsetting transaction for the same security futures contract prior to the contract date, which is often referred to as the delivery or contract expiration date.
In order to eliminate counterparty credit risk, exchange-traded security futures contracts are generally cleared through a clearinghouse, which becomes the central counterparty to both sides of the transaction. For example, in the United States, the Options Clearing Corporation which currently has an AAA credit rating from Standard & Poor's acts as a clearinghouse for security futures contracts.
An example of a specific type of security futures contract presently being traded on an exchange are single stock futures contracts traded on the OneChicago exchange. On the OneChicago exchange, most single stock futures contracts have a total of four expiration dates per active product class. These expiration dates typically include two monthly expirations—for the current and next month—and two forward quarterly expiration dates. For example, a single stock futures contract being traded in January would have expiration dates of February, March, June and September of that same year. The only U.S. exchange currently offering trading in single stock futures contracts is OneChicago, although other exchanges could list and trade the products if they choose.
In order to initiate a trade in single stock futures contracts, the buyer and seller typically must put up a good faith deposit in an interest-bearing margin account with their broker (in the United States, an SEC-registered broker-dealer or a CFTC-registered futures commission merchant). The security deposit (“margin”) required is generally 20% of the cash value of the contract.
Single stock futures contracts generally conform to a theoretical pricing model based on the following formula: futures price=stock price×(1+(annualized interest rate/365)×days to expiration)−dividend due before expiration. Single stock futures contracts typically trade at a premium to the cash or “spot” value of the underlying security because they contain an interest rate carry component. The premium reflects the carrying costs of owning the underlying security from trade day to expiration. Since the holders of single stock futures are not entitled to collect dividends, the price is discounted by the amount of any expected dividend due prior to expiration.
Investors may combine a transaction in a security futures contract with a simultaneous transaction in the underlying security (together called an “Exchange for Physicals” or “EFP” trade). An EFP trade allows the swap of a long or short security position for a security futures contract. There are several reasons why an investor would enter into an EFP trade. One reason is to earn a higher return on cash balances in the investor's brokerage account. The investor could buy a stock and sell a single stock futures contract at a premium higher than the interest that is generated on the cash balance in the investor's brokerage account. By way of example, an investor with a margin account at a broker may use available funds for which he or she wishes to receive an interest rate return to purchase a security (e.g., 1000 shares of IBM stock). To effect an EFP trade, the investor will then sell single stock futures contracts covering the same number of IBM shares. Because single stock futures contracts typically trade in multiples of 100 shares per contract, the investor, in this example, would sell 10 IBM contracts. After these two offsetting transactions comprising the EFP trade are made, the investor is “delta neutral,” i.e., he or she has no exposure to the price movement of the underlying security and, thus, is indifferent to whether the price of IBM stock rises or falls. On the one hand, if IBM's stock price rises, the investor will profit on the long stock position, but lose an equal amount on the short single stock futures position. On the other hand, if IBM's stock falls, the investor will lose value on the long stock position, but gain value in an equal amount on the short single stock futures position.
The objective of the EFP trade is not to profit by the change in price of the underlying security, but rather to receive a return on the funds invested in the EFP trade via the premium the investor receives from the sale of the security futures contract. As noted above, the security futures contract that was sold by the investor trades at a premium to the underlying security that was bought by the investor. Thus the investor will receive somewhat more for his sale of the security futures contract than the cost of his/her purchase of the underlying security, representing implied interest on the funds that are invested in the transaction. The absolute amount of the interest depends on the premium that was implied in the security futures contract, which in turn depends on market interest rates plus the length of time until expiration of the futures contract.
The EFP trade illustrated above represents a way for the investor to lend his/her available cash to the market at an interest rate return that will typically be more favorable to the investor than the rate of return the investor would be paid for cash balances in his brokerage account. In addition, since security futures contracts are settled through the Options Clearing Corporation, an AAA rated entity, earning interest by means of an EFP trade is safer than many other interest earning alternatives. Essentially, the EFP trade allows an investor to make a fixed-duration loan (i.e., the investor is financing somebody else's position on a fully secured basis), at a fixed rate of return to the market in order to get a better interest rate return on free cash. The “loan” expires upon expiration of the security futures contract (when the short futures contract expires, the long stock in the investor's account is sold and the investor receives his/her cash back).
However, the current, fixed expiration cycle for security futures contracts, i.e., the four available expiration dates, significantly limits the usefulness of the EFP trade as a vehicle for lending free funds to the market, because the term of the loan is limited to the time between the initiation date of the transaction and one of the four available expiration dates. This is because to maximize the rate of return on the EFP trade the trade must be held until expiration of the security futures contract. Unwinding the EFP trade prior to the expiration date (e.g., by buying back the futures contract and selling the security) exposes the investor to various market conditions, including but not limited to interest rate fluctuations. Moreover, by unwinding the EFP trade prior to the expiration date of the selected security futures contract, the investor will likely not realize the full implied interest rate of return of the initial EFP trade, because the premium implied in the security futures contract may have changed based on the fluctuation of interest rates which will be reflected in the price that the investor pays to buy the security futures contract in order to cover that side of the trade. Thus, unwinding the EFP trade early is typically not a way for an investor to tailor the duration of the “loan” of his/her funds to the market, because the implied interest rate the investor receives will not be locked in. The better way to lock in a given rate of return is to hold the short security futures position until it expires. Thus, it would be much more useful if the investor or other counterparty to the trade could select the expiration date for the security futures contract. If this were the case, then the investor or other counterparty could enter the EFP trade on any business day and could tailor the expiration of the transaction to the exact date on which the investor wishes for the “loan” to expire and to have his/her funds paid back. This would allow the investor to loan out his free cash via an EFP trade for 1 day, 2 days, 3 days, 81 days, etc., depending on his/her specific cash flow and investment needs.
Consequently, there is a long felt, but unresolved need, in the art for a security futures contract that could be traded either as a standalone financial instrument or in connection with an EFP trade that permits the selection of an expiration date for the security futures contract.